Token Daily Research

Will Binance Chain & DEX Succeed?

By Imran Khan & Mohamed Fouda

Binance has adopted the move fast and break things model which is similar to Facebook's strategy in the early days. Since launching in 2017 they have expanded globally choosing Malta as their home jurisdiction. Coinbase, on the other hand, is in fierce competition with Binance and both are eyeing international growth as future revenue drivers. Which means that the total addressable market has much more room to grow. So as exchanges compete for the international markets, customer acquisition growth in these markets will be the leading indicator of whether one exchange will dominate most. Binance has established itself as one of the global crypto exchanges people use, can it keep its title while the regulators catch up?

The Opportunity

Binance could outmaneuver regulators while creating an opportunity around its chain and DEX. It's an opportunity and a way to mitigate potential regulatory scrutiny from different parts of the world. We can anatomize the chain and DEX as two separate opportunities. The first opportunity is by moving to its own DEX it would effectively give up some control of the exchange. This move would make it harder for regulators to come after Binance as a centralized entity. The second opportunity is by creating its own chain, they can effectively court projects that plan to launch on Ethereum or on other chains. Binance could lock in projects into its chain while using the DEX as a way to gain exposure to the potential network effects of users and the liquidity it brings.

By targeting current Ethereum projects it could bring significant users and activity to its chain. For example, while announcing Mainnet release, CZ touted that at least 8 projects have switched from Ethereum to its chain like the social platform Mithril. Projects that are looking for a shot in the arm, are eyeing Binance Chain as the platform of choice. The strategy devised by CZ and his team sounds auspicious and like everything else, may work due to sheer scale and relentlessness. But based on our research, there are hurdles in place that could trip its growth.

Specifically:

Binance's control of the blockchain creates regulatory concerns for BNB and other BEP2 tokens.

Platform Risk and Centralization as Binance is the only entity allowed to issue pegged-tokens.

In this article, we analyze the noted risks. But first, we need to understand the fundamentals of Binance Chain and DEX and learn why CZ's strategy could go wrong if left unchecked.

What is Binance Chain & DEX?

Binance DEX is built on the Binance Chain and its intended use case is to facilitate fast non-custodial trades that can match the performance of a centralized exchange. This allows users to hold on to there own private keys while being able to trade with others on the platform. High-level benefits for users are privacy guarantee, exchange hack protection and being a part of the DEX listing community. Benefits for Binance is that they own the entire stack from the chain to its DEX application.

This would give them more control over user experience and the ability to create new profit-making schemes. They have opted to run on Cosmos and is implementing a practical Byzantine Fault Tolerant (pBFT) consensus algorithm which is a fork of Tendermint. The goal, for now, is to deploy pBFT algorithm with limited validators (11 validators running currently) but to eventually introduce a delegated proof of stake (dPOS) consensus. Similar to EOS, this would give them the throughput that they are looking for without sacrificing usability.

Regulatory Concerns with Binance Chain

Running centralized crypto-exchanges in any jurisdiction globally can cost millions of dollars in overhead and neverending legal disputes. To overcome this, Binance has taken an intriguing approach by building and partnering with countries such as Malta, Singapore, and Nigeria. This gave them the initial approval in some countries so that it can lay its foundation. Eventually, if they wanted to expand to other countries and continue to be a global crypto exchange it has to work with regulators. Working with regulators can be costly, time-consuming and can stunt growth as you are retooling an exchange based on the needs of a jurisdiction.

This is where Binance chain & DEX shines by effectively giving up some control of the exchange and allowing the network to facilitate user activity. Its chain & DEX could go after any market of any size. This strategy is not going to win overnight and requires a lot of control up front. By controlling the chain initially, users can have a stable platform but can also expose the exchange to regulatory risks.

CZ outlined the following, "Do we have a lot of influence over the network and the validators? Yes, we do. So initially, we want the chain to be more centralized in that way, compared to other networks, we'll have a little bit more influence. But I think it's important for us to maintain that influence in the early stages. As time goes on, more and more validators are going to join, and our influence will decrease."

When a project decides to join Binance Chain and develop its own token, it would issue a BEP2 token. You can think of BEP2 token implementation similar to the ERC20 token implementation on Ethereum. Binance is building the chain and migrating its exchange token BNB. Since Binance has main control over the chain and the DEX early on, the SEC could deem the BNB token a security, as the SEC has empirically stated a project is a security if it is not decentralized enough while exposing retail investors to profit-sharing mechanisms.

Dean van Dugteren succinctly explained that in Malta where Binance is based, there are two types of classified assets, Virtual Financial Asset, and a Virtual Token. Dean stated, "A token is a VFA when the issuer intends for it to be traded on exchanges or hold some monetary value in order to realize its utility." A VT applies to projects that intend to use it for a utility such as games, loyalty points or credits. As some have implied, it seems as if Malta could deem BEP2 tokens as a Virtual Financial Asset. Which may have forced Binance to update its whitepaper on April 18th and remove terms about buying back its tokens. This pressure may be a forcing function to launch the chain and DEX quickly so that it can deal with regulatory concerns and continue to sustain its growth. Could Binance deploy its chain and let go of its control quickly enough to escape regulators?

Centralization & Platform Risk

As investors, we welcome experiments that lead to improved user security along with improving the usability and user experience of the platform.
However, when reading through the FAQ, we've flagged a few items:

Binance has announced that you can trade Bitcoin and Ethereum via a pegged BEP2 token

Projects have systemic risks such as composability and centralization when trusting Binance Chain as its only platform.

Atomic swaps, which is required for true non-custodial trades, are not going to be implemented initially and only promised in the future

In order for a trader to trade Bitcoin on its DEX, they would have to first deposit a native Bitcoin and in return, they would receive BTC-B (a BEP2 token pegged to BTC). We have pulled total adjusted trading volume within the past 24 hours for Binance through OpenMarketCap. Binance has done over $1.1B in trading volume of which only $117M is done in BNB. The rest of the $1B in trading volume is being done with Bitcoin, Ethereum and the remaining altcoins. How will Binance bring in traders to its DEX with just BNB and a handful of projects?

In order for its DEX to capture meaningful market share, they would have to aggressively migrate projects over or create pegs to lure investors onto its DEX. Pegs will bring in users, and users could continue to deposit their native tokens and receive pegged tokens. Over time, Binance could move its assets from its centralized exchange over to the decentralized exchange while users are trading in pegged tokens. Once again, the question is can Binance execute this strategy quick enough before users realize that the deposited assets are moving from one platform to the other?

The second concern is something Spencer Noon has written about. Projects that are moving to Binance Chain could face additional hurdles. Binance's early control of its chain could dissuade entrepreneurs from building on its platform since they'd be overly dependent on Binance, reintroducing the same platform risk traditional software companies are trying to combat. Take for instance Zynga, a gaming platform built on Facebook, whose DAU dramatically dropped (and future growth suffered) when Facebook changed its platform policy.

Finally, projects that have decided to move from Ethereum to Binance chain could lose composability with existing projects such as Dharma, Augur, MakerDao, Uniswap, and others. This is important because platforms that have existing composability can offer developers building blocks to build much more revolutionary products. Maker Dao's stablecoin powers Open Finance and brings in users that want to use its DAI for things like lending and prediction markets. Composability creates stickiness that gives entrepreneurs an existing set of customers to work with. To this degree, we are curious about Binance's approach to composability and what sectors it will target for its chain.

Counterparty Risks of Pegged Tokens

Trading assets like Bitcoin on Binance Chain require a third-party, initially Binance itself, to hold the asset and issue pegged assets like BTC.B that can be traded on its DEX. This introduces a counterparty risk that is no different than using a centralized exchange. While the pegged asset (BTC.B) remains in the trader's custody until a trade is executed, the original asset (BTC) is held by Binance or a third party. There is no guarantee that the pegged asset can be swapped back to the original asset other than the trader's confidence in the brand.

Atomic Swaps to Enable True Non-Custodial Trades

To mitigate this counterparty risk the traded asset has to migrate from the native chain to the Binance Chain (like the altcoins that announced their migration from Ethereum to Binance Chain). For the assets that are not going to do this migration like BTC, the alternative is to allow trustless atomic-swaps between the original asset, i.e., BTC, and BEB2 tokens. Atomic swaps, in this case, will eliminate the counterparty risk.

Atomic swaps are generally possible between assets that use the same code base, for example, BTC, BCH, and LTC. Currently, it is not possible to scale cross-chain atomic swaps between Bitcoin and Ethereum. There are multiple efforts to enable atomic swaps between the Bitcoin-based chains and Ethereum such as Summa. Moreover, there is some research going on to use Lightning Network (LN) to enable BTC atomic swaps with ERC-20 tokens. However, these efforts need further technical changes that will take considerable time to be implemented. Hence, we think the implementation of cross-chain atomic swaps between BEP2 tokens and other non-native assets is unlikely in the short-term.

Another issue with atomic swaps is price discovery, in atomic swaps, the buyer and seller have to negotiate a price before executing a trade. However, this problem was recently mitigated through the technology implemented by Arwen. The Arwen technology stack allows the integration of atomic swaps with centralized exchange order books allowing for fair and efficient price discovery. The technology implements blockchain-based escrows that hold the trader's coins and performs atomic swaps at the market price, when the trader executes a trade on the centralized exchange.

The Arwen technology was integrated into the KuCoin exchange to allow non-custodial trades. Similarly, the same technology can be integrated with the Binance centralized exchange. However, integration with its DEX, would require Arwen to support Binance Chain escrows and implement atomic swaps between Binance Chain and Bitcoin-based assets. If such a development can be achieved, true non-custodial exchanges on Binance DEX could become a reality.

Conclusion

Binance DEX and the accompanying implementation of its chain is an ambitious move from Binance to lead the disruption on the crypto exchange industry. While we agree with the massive potential of the long-term goal, it is important to realize and highlight the major hurdles toward realizing that vision. Specifically, Binance has complete control of its chain, and the assets issued on it, which could pose a significant risk from both regulatory and execution perspective. Moreover, the issuance of pegged assets for major cryptocurrencies like BTC, ETH, and ZEC to allow trading on its DEX doesn't provide any tangible improvement over the current centralized exchange experience. In both scenarios, Binance is holding the original assets that are traded on the exchange.

Disclosure: The information in this article is for informational purposes. At the time of this article, we have no investments in Binance, KuCoin, Arwen or any positions in BNB, KCS.

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